Consumer Behavior

Question at the outset: Hulu introduced a new commercial free version of its subscription service for $11.99/month. Is the new pricing based on the share of value to customers or the need to offset lost Ad revenue?

For those cutting chords (figuratively speaking) – removing cable TV option and satellite TV – Hulu has been the go to option to catchup on TV shows. For $7.99 a month subscription fee Hulu offers its customers current and full season episodes of most popular TV shows (some network exceptions apply based on their content licensing agreement). Seems better option to customers than paying cable TV bill or struggling with Over The-Air Antenna.

What viewers get for the price is unlimited and on-demand streaming of TV shows. Just like a TV show is interrupted by commercials (even in the pay-Cable ones) viewers see commercials. Sometimes these are the same that aired with the show and other times different ones inserted. But the experience is the same – 30 minute sitcoms and 60 minute murder mysteries filled with 10%-20% commercials.

Some of those paying customers are not too happy to be interrupted by the commercials – limited or not. Clearly demand for such Ad free TV shows exists, Netflix and Amazon are quite successful even though they do not offer current episodes like Hulu does. Seeing this pressing customer need to be not interrupted Hulu is introducing a No Commercials version at a price of $11.99 per month.

The price difference is $4 for no interruptions. I have always said many times before, “If one price is good, two are better“. So isn’t this better for Hulu and its customers? The answer is a qualified yes.

We need to consider the reasoning and logic behind the $4 price difference for no interruptions. Is that based on customer research and value they assign to for interruption free TV shows (hopefully done using some kind of conjoint analysis)? Or is the pricing done to offset the lost revenue from Ad sales from the premium version?

It is possible Hulu is using one of two revenue metrics

Average Revenue Per User (ARPU)- measured as a sum of subscription fee of $7.99 and Ad revenue from the average user

Total revenue measured as sum of all subscription revenue and sum of all Ad revenue

In case 1 it may see the need to keep ARPU the same and may simply came up with a price point of $11.99 which is likely its ARPU.

In case 2 it may see the erosion in Ad revenue, model possible uptake and come up with per user uplift in pricing needed.

Both cases are wrong as they start with Hulu’s costs over value to customers. In fact there is evidence to point out cost based pricing is how Hulu set its price of $11.99 according to this news article:

Hulu and its owners don’t want to encourage large numbers of existing subscribers to shift to the new ad-free service

That is they are using case 2 above and modeled in small enough uptake of new version and shaping that expected customer behavior with a higher price tag.

It is perfectly normal and acceptable effective pricing practice to shape customer behavior with higher price point. For instance amusement parks set a high price for Fast Pass and other similar options to skip lines to reduce uptake. After all if the price is low enough and many take it the lines at FastPass will degrade value to customers.

But using higher price point just to support a model assumption on Ad revenue loss without measuring customer value is simply not effective pricing.

Instead of scanning the road for bad drivers, traffic police in one town south of Paris, are looking for drivers who are obeying the rules of the road. They’re pulling over good drivers at random, and handing them gas vouchers worth more than $60.

People respond to incentives but they respond more to disincentives or negative incentives. According to Prospect Theory the satisfaction from a gain of $60 gas voucher is not as intense as the pain from losing $60 (or more) to traffic tickets. Besides, I am not sure who would enjoy being pulled over even if it is for being presented with a gift for obeying traffic rules.

When it comes to changing behaviors sticks are better nudges than carrots.

Here is another study on the effect of Stick vs. Carrot reported in today’s WSJ that validates the power of sticks over carrots:

Our main findings are that reemployment bonuses don’t seem to have worked, while benefit sanctions increased the job finding rate significantly,” the economists write.

Like this:

You have $X dollars to be used as promotional discount to increase your product uptake, i.e., maximize number of subscribers rather than maximize profit. You have two versions of your product, Silver priced at $19 and Gold priced at $49. How will you allocate the promotional dollars to drive most uptake? Will you discount your Silver version, Gold version or split between both?

Sidebar: I understand I have consistently advocated about profit maximization and not using price to drive volume. But let us assume you have a very good reason to do that and it is not permanent price drop but a controlled price promotion. May be you have a freemium model with a Bronze version at $0 and want to move most free customers to paying customers.

Consumer behavior research says, based on Prospect Theory (Kahneman and Tversky 1979), you are better off spending the promotional budget on discounting the lower priced version than the higher priced version. While rational economics states (assumed?) a $5 discount is the same regardless of the price, consumers look at $5 with reference to the base price. Consumers value $5 discount on $19 version more than then do the discount on the $49 version. So discounting your silver version maximizes new customers.

However there is an exception – when customers’ reference price (the price they expect to pay for similar products regardless of their economic value) is lower than the price you charge. Here the effect is reversed so you should discount the Gold version. If you are interested in understanding this case please write to me.

In either case, you are better off allocating the promotional budget to just one version and not dividing between two versions.

Does presence of customer reviews and the number of reviews drive down returns by customers?

According to Internet Retailer (thanks to Gerardo for the link), that is the case. The article says, reviews has helped Petco considerably

Petco’s approach to gaining more customer reviews has paid off. On average, products with reviews have a 20.4% lower return rate than products without reviews. The return rate continues to decline as a product gains more reviews. Products with more than 50 reviews have a 65% lower return rate than products with no reviews.

Since returns eat into profits, reducing returns goes directly to the bottom line – there is no question here. But can presence of reviews drive down returns? Is there a direct causal relation or is this just incidental correlation.

Commitment and Consistency Bias: If the case of customers who took the time to write reviews I can see that their return rate will be much lower than the return rates among those who did not write one. This is the Commitment and Consistency bias (the book Influence by Robert Cialdini has very good discussion of these biases). When the customer “commits” by writing how good they feel about the product their internal system compels them to act consistently to their previous commitment. So they keep the product.

Reason doesn’t matter: This does not mater whether or not customers wrote the review because of their LOVE for the product or because they were paid in coupons or raffles. This does not apply to negative reviews, but according to one research, most reviews are positive reviews and there is generally high product ratings. On the other hand we could argue that those who returned the products are more likely to write a negative review.

Conformity Bias: Commitment and consistency bias alone cannot explain the drop in returns because this is still a small number of reviews compared to products sold. But another cognitive bias that could be at play is conformity bias. When customers make the purchase based on many reviews by “customers just like them”, they tend to confirm to those peer reviewers. This will compel them to “like” the product and keep it – all those positive reviews cannot all be wrong, if I do not like the product it must be me. Again, Cialdini has chapters describing Conformity bias in his book.

Cognitive Dissonance: Intertwined with conformity bias is our need to assuage cognitive dissonance. People who buy a product by doing the research, reading multiple reviews and evaluating options believe they made a rational decision of buying the best possible product. But after buying the product if it turns out that it did not live up to their expectation they suffer cognitive dissonance – a gulf between how their feelings before and after the purchase. Customers overcome that by convincing themselves that they like the product.

On top of these cognitive biases, it is possible that there exists another common variable that both drives up number of reviews and drive down returns – for example the product experience matches its promise.

There is one way to answer many of these questions and to find out whether or not number of reviews drive down returns. It requires doing two sample test, showing some of the customers the review, suppressing it for others and tracking the respective return rates. If the return rates are statistically significant then we can declare presence of reviews drives down product returns.

Next step, if we do the experiments by showing different number of reviews we can even find the linear causal relation between number of reviews and returns.

This has been my favorite pricing case study for the past ten months or so – Sensorielle spa in the city I love, Boulder, went to a Pay-what-you-can pricing model. The spa’s owner, Ms. Petteway made it clear that this is not “pay what you want” but a scheme to allow those loyal customers who were hurt by down economy to come back and pay only what they could afford.

Ms.Petteway published results from her experience in the Boulder Net LinkedIn discussion board. She talks about how few customers interpret the pricing plan as “pay what I want” and ask for high-end services even though they pay less than the posted prices. For any rational customer (Homo Economicus) whose goal is to maximize their utility, it makes sense to pay the minimum they can get away with.

I said then Pay-what-you-can scheme despite its close resemblance to first order price discrimination is not really price discrimination. It does not stand on solid data ground or analysis and leaves the future profit uncertain. Better results could be achieved with segmentation and targeting.

Will this pricing scheme help the spa identify willingness to pay of different customers? No, because the reference price is set by the list price and is pushed down by the option for “pay-what-you-can”. There are other ways to get customers to reveal their true willingess to pay (see my article on Pricing for garage sale).

I do not have access to any sales data nor have I had this conversation with Ms.Petteway but I hypothesize that they found this pricing scheme yielded lower profit than previous years. The spa is not standing still and is making more pricing changes for the coming year:

The Pay-what-you-can is limited to just two days of the week. This is something they should have done to start with and that would have been a great way to sort customers based on their WTP. This would also help reduce cost of operations for those days by staffing with junior staff and not offering their high margin services. I also would recommend offering no reservations or charge for reservation separately (unbundled pricing) for these pay-what-you-can days.

They are increasing prices of some and decreasing prices of some. If they based it on customer survey then it makes perfect sense. When re-pricing two version of the same service I would have recommended that they don’t reduce the price for both.

Note how the text reads for price decrease and price increase. They say “price reduced” and “price changed” respectively. That is not a strategy but the right messaging – do not ever say price increase.

Small businesses can blame the economy and be swept by the recessionary wave or they can take control on their marketing strategy to drive higher profits. Lack of specific marketing skills is not an excuse anymore. Kudos to Ms.Petteway for experimenting with pricing and her willingness to adapt as she gained more data about consumer behavior.

Yesterday I was at a Borders bookstore. The checkout line was long and growing. At one of the counters a grandmother and her granddaughter were in the process of completing their transaction. The grandmother had allowed her granddaughter to buy one of the trinkets (glowing ball, etc.) that Borders stacks plentiful along the check out area. But the little girl had two items in her hand and was indecisive. The checkout clerk, not wanting to spend idle cycles on girl’s indecision, took a coin out of his pocket and flipped stating heads this and tails that.

Then magic happened. Before even the clerk revealed the outcome of coin toss, the little girl said, “I will pick this one” and returned the other item.

Behavioral economists say it is our natural tendency to pick options that seem certain over options that are associated with uncertain outcome. When the clerk flipped the coin it became clear to the girl that she might end up with an item that she preferred less and hence was forced to make a choice. Next time you are with an indecisive partner, try flipping a coin.

Kudos to the clerk for understanding consumer behavior, and keeping the line moving. I am not sure if Borders trains their clerks or the clerk read the many books on behavioral economics in the store.